A Survey of the World’s Top Stock Exchanges’ Trading Mechanisms And Suggestions to the Shanghai Stock Exchange Contents I. Introduction……………………………………………………………………………………1 II. Trading Mechanisms…………………………………………………………………………2 Types of orders……………………………………………………………………………2 Order precedence rules…………………………………………………………………..11 Market structures………………………………………………………………………...14 Order driven markets…………………………………………………………….15 Market makers/dealers, and specialists…………………………………………..18 Quote-driven markets…………………………………………………………….21 Brokered markets………………………………………………………………...23 Hybrid markets…………………………………………………………………...24 Block trading mechanisms……………………………………………………….25 Bond trading mechanisms………………………………………………………..28 Market information and order execution systems………………………………………..31 Trade pricing rules……………………………………………………………………….33 Trading halt rules………………………………………………………………………...35 Summary of the world’s top stock exchanges’ trading mechanisms…………………….36 III. Suppliers of Liquidity……………………………………………………………………...38 Dealers Block traders Value traders Arbitrageurs Buy-side traders Liquidity and orders IV. Recent Developments………………………………………………………………………43 V. Comments and Suggestions…………………………………………………………………51 More types of orders Market makers/dealers and institutional traders，OTC markets Dealer margin account, bank funds into stock market Block trading systems Short sales Elaborate call auctions Smaller minimum price increment More trading platforms Futures and options on T-bonds and stock indices A sign of the SEE? References……………………………………………………………………………………….57 0 A Survey of the World’s Top Stock Exchanges’ Trading Mechanisms And Suggestions to the Shanghai Stock Exchange Anthony Yanxiang Gu1 Abstract A variety of types of orders, market makers, dealers, and trading platforms are proven successful and necessary trading mechanisms in the world’s top stock exchanges, which may provide valuable references to the Shanghai Stock Exchange where the introduction of more types of orders, market makers, dealers, block transaction mechanisms, elaborate call auctions, and trading platforms will animate trading. I. Introduction Upon request of the Shanghai Stock Exchange (SSE) we survey the world’s top stock exchanges’ trading mechanisms, discuss the advantages and disadvantages of the factors of concern, particularly types of orders, market structures, dealers, market makers, and trading platforms. The purpose of this project is to further understand the world’s top stock exchanges’ trading mechanisms and to provide references and suggestions to the SSE, especially the successful trading mechanisms in the top exchanges that may be used at the SSE. All the top markets in the world operate with a variety of types of orders (more than 20), dealers, market 1 Visiting Senior Financial Economist at the Shanghai Stock Exchange, David Martin Professor of Finance and Economics, Jones School of Business, State University of New York, Geneseo. The author wants to thank James Angel, 丁桦, 方星海， 胡汝银, 胡日新, 刘逖, 吕劲, 王风华， 杨秋梅，曾刚 for very helpful suggestions, 王风华 and 辛亨 复 for their assistances, and金岩石, 江巍, 李康, 唐克川, 唐庆春, 王叙华, 吴万善, 左小蕾for their opinions. 1 makers, and trading platforms. Currently the SEE accepts only limit orders. There is no market maker or dealer in the stock and bond markets, and there is only one trading platform in the markets. Only one type of order may be convenient for the SSE, but more types of orders will meet the needs of various traders and generate more fees to the SSE. Dealers, market makers, well-developed institutional traders, and more trading platforms are necessary for supplying liquidity and enhancing trade at the SSE. We interviewed executives of securities firms, traders and researchers for their needs for other types of orders, dealers, market makers, and trading platforms, discussed potential risks or problems, and possible solutions or balances. We conclude that in order to activate and enhance trading, and to strengthen the markets in China, the SSE may adopt the proven successful trading mechanisms in the most developed markets, which should help pave the way for the SSE to be an outstanding stock exchange in the world. The report is organized as follows, Section II discusses the world’s top stock exchanges’ trading mechanisms of interest, Section III examines suppliers of liquidity, Section IV introduces the recent developments in the most developed markets, and Section V reports our comments and suggestions. II. Trading Mechanisms In this section we discuss the trading mechanisms, including types of orders, order precedence rules, market structures, the need for market makers, dealers, trade pricing rules and trading halt rules. We try to avoid details that are not necessary for this project2. II.1. Types of Orders 2 Readers who are interested in details of trading mechanisms may read the articles and books listed in the references. 2 There are over twenty types of orders in the most developed markets, of which, market and limit orders are the two standard orders, other orders are based on the two standard orders with attached contingences. We will discuss the purpose of using each type of order, its impact on market liquidity and price. Market orders A market order is an instruction to trade at the best price currently available in the market. All exchanges in developed countries accept market orders. Market orders usually fill quickly. Impatient traders, informed or uninformed, may use market orders. Market order issuers pay the bid/ask spread for receiving liquidity or immediacy. Execution of a market order depends on its size and on available liquidity in the market. The issuers of market order face execution price uncertainty, i.e., their orders are sometimes executed at inferior or better (price improvement) prices than the prices they saw when they submitted their orders. Traders who are concerned about the execution price uncertainty may submit limit orders. Limit orders A limit order is an instruction to trade at the specified price or better. A limit order will stand as an offer to trade until someone is willing to trade at its limit price, until it expires or is canceled. All exchanges in developed countries accept limit orders. Standing limit orders are placed in a file called a limit order book. Limit orders are usually far from the market when the market is volatile. Patient and absent traders prefer to use limit orders. Limit order issuers are supplies of liquidity in the market, they receive better average price as compensation for supplying liquidity. The execution uncertainties that limit order issuers face include time and 3 trade uncertainties. The time when the order will be executed and whether they will trade is not known, the limit order may expire without being executed. They also face the risk of ex post regret, the market price can be much worse than the limit after the order is executed if the market moves against them in response to some significant news. Stop (loss) orders A stop (loss) order is an instruction that stops executing the order until price reaches or passes a stop price. Stop orders are accepted by most exchanges or handled by brokers in developed countries. With stop instructions traders may buy only after price rises to stop price or sell only after price falls to stop price, or when prices move against them. There are two types of stop orders, stop market order--the order becomes market order once the stop price is reached, and stop limit order--the order becomes limit order once the stop price is reached. Two prices must be specified for a stop limit order, the stop price and the limit price. A trader with a long position may use a stop sell order to close the position if the price declines significantly. A trader with a short position may use a stop buy order to cover the short position if the price increases significantly. Stop order issuers demand liquidity when it is less available and hence accelerate price changes, or they add momentum to the market. Prices often change because traders on one side of the market demand more liquidity than is available. When these price changes activate stop orders, the stop orders accelerate price changes by adding buying pressure when prices are rising and selling pressure when prices are falling. Momentum traders buy when prices are rising and sell when prices are falling. They destabilize prices. They use stop, market and limit orders. 4 Contrarian traders buy when prices are falling and sell when prices are rising. They supply liquidity and stabilize prices. They use limit orders. Many regulators, traders, and exchanges are concerned about the destabilizing effects that stop orders and momentum strategies have on the market, it is related to front runners, market manipulation, and extreme volatility. Market-to-limit orders A Market-to-limit order is an instruction to trade at the auction price, or the best limit price, if this limit is represented by at least one limit order and if there is no market order on the other side. Any unexecuted part of a market to limit order is entered into the order book with a limit equal to the price of the executed part. Market-if-touched (MIT) orders A market-if-touched order is an instruction to activate a market order when price touches (reaches) a specified touch price. With market-if-touched orders traders may buy when prices fall to their touch prices or sell when prices rise to their touch prices, or when prices move in their favor. Traders who want to trade when prices reach their touch price may use MIT orders. MIT traders stabilize the market because they buy when the market is falling and sell when it is rising. In a broader sense, MIT traders supply liquidity because they offer liquidity to traders who push prices to their touch prices, thus decrease the price impacts of other traders. In a narrow sense, MIT orders demand liquidity because they become standard market orders that demand immediacy when they are triggered. 5 Tick-sensitive orders A tick-sensitive order is an instruction to activate a market order that is related to previous prices. Ticks include uptick, downtick, zero tick, zero down tick, and zero uptick.